How Did the Central Banks in the U.S. and Europe React to the Global Financial Crisis?

By Taryn Dozark-Frideres March, 2010 This section addresses the role of central banks in the global financial crisis. First, it looks at the normal role of central banks and at the unusual role of "lender of last resort" that central banks take on in a crisis. Next, it considers the role that three major central banks the Federal Reserve, European Central Bank, and Bank of Englandplayed in the global financial crisis. Finally, it compares and contrasts the responses of these three central banks and considers how central banks should respond in future crises. A. Central Banks Took on Additional Roles in the Global Financial Crisis A central bank is a public entity, usually affiliated with a national government, that performs a number of key functions, including: issuing the nations currency, regulating the supply of credit in the nations economy, managing the external value of the nations currency in the foreign exchange markets, holding deposits representing reserves of other banks and other central banks, acting as a fiscal agent for the central government when the government sells new issues of securities to finance its operations, and attempting to maintain an orderly market in these securities by actively participating in the government securities market. However, during a financial crisis, central banks often take on additional roles. Most importantly, in a credit crisis, the central bank often becomes the lender of last resort in order to guard against systemic risk in the banking sector and to support interbank lending. Interbank lending consists of banks loaning money to each other, typically for a short-term

period, in order to meet reserve requirements. The rate at which these loans are made is called the interbank rate. During the global financial crisis, banks were wary of lending to one another, resulting in a rise in the interbank lending rate and the freezing up of credit. The credit freeze forced banks to seek liquidity from the central bankthe lender of last resort. In fact, some suggest that lack of confidence in private money markets during the crisis resulted in central banks becoming, at least temporarily, the lender of only resort. This phenomenon resulted in central banks worldwide taking unprecedented actions in order to respond effectively to the crisis. During the global financial crisis, three central banks played an important role in attempting to prevent and control the crisis. As the crisis became a global financial and economic crisis, other central banks also became involved, but the actions of the Federal Reserve, the European Central Bank, and the Bank of England remained the focus of attention. General background information about each central bank will be helpful in understanding the banks respective responses to the crisis. The Federal Reserve (the Fed) is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable financial system. Specifically, the Fed was dually mandated to promote stable prices and maximize employment. Today it is charged with the primary task of regulating monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates. When it decides to change monetary policy, the Federal Reserve Chairman announces these changes at the Federal Open Market Committee (FOMC) meetings. Through the FOMC, the Fed buys and sells financial instruments in order to influence interest rates and the availability of credit.

The federal funds rate is the interest rate that banks charge each other on overnight loans. The federal funds rate is a target rate, and changing it triggers a chain of events that affects other short-term interest rates, long-term interest rates, foreign exchange rates, and the amount of money and credit in the economy. Therefore, the Fed changes the rate in order to regulate the supply of money in the U.S. economy. A rise in the rate curbs economic growth and helps contain inflationary pressures, while a decline in the rate stimulates economic growth. The Fed responded to the global financial crisis by aggressively lowering the federal funds rate several times. In addition to lowering the federal funds rate, in a liquidity crunch the Fed may use a lending tool called the discount window. The discount window allows institutions to borrow additional cash from the Fed at the discount rate. To discourage unnecessary use of the discount window, the discount rate is usually higher than the federal funds rate. However, during the global financial crisis, the stigma associated with borrowing from the discount window acted as a disincentive to institutions that might otherwise have borrowed from it. In addition, borrowers were required to seek funds elsewhere before coming to the window, making institutions reluctant to borrow from the discount window. Together, these factors worked to reduce the discount windows effectiveness. In response, the Fed acted in extraordinary ways, creating new and innovative tools to help struggling financial institutions obtain credit and avoid failure. The European Central Bank (ECB) was created in 1998 and is responsible for monetary policy covering the sixteen current members of the Eurozone. Thus, it functions like the Federal Reserve, except that it holds the official foreign reserves of the member states of the European Union and has co-authority with those states to issue currency. The ECB typically

makes general monetary policy decisions independently and then relies on the member states central banks for implementation. However, the Statute of the European System of Central Banks does not clearly indicate to what extent ECB policies are to be implemented through activities of the ECB or national central banks. Thus, generally, the ECB and member-state central banks act jointly, although the Statute does require that the ECB must take the responsibility to ensure that all tasks are carried out properly and consistently. To that end, the ECB does have the power to issue guidelines and instructions to the national central banks. Further, the ECB does have some independent power to affect interest rates. In order to affect interest rates, the Governing Councilthe main decision-making body of the ECBbuys and sells currency and increases and decreases liquidity. In addition to defining and implementing the monetary policy of the Eurozone, the ECBs primary objective is to maintain price stability. In this capacity, the ECB maintains high levels of independence. The Bank of England (BoE) was established in 1694, became state-owned in 1946, was given the statutory responsibility of setting the U.K.s official interest rate in 1997, and was finally granted operational independence over monetary policy in 1998. Currently, the two core purposes of the BoE are to promote monetary and financial stability. In pursuit of these goals, the BoE sets the bank ratethe U.K.s official interest rateand is responsible for meeting the inflation target set by the Chancellor of the Exchequer. The BoE also lends to financial institutions by offering short-term borrowing rates. The BoE is less independent than the Federal Reserve and the ECB, as it has to share the duties of promoting market stability with Her Majestys Treasury (the HM Treasury)the U.K.s economics and finance ministryand the Financial Services Authority (FSA), an independent body that regulates

the financial services industry in the United Kingdom. More specifically, the HM Treasury has responsibility for the overall institutional structure of regulation and the legislation that governs it. The FSA is responsible for the authorization and supervision of financial institutions, for supervising financial markets and securities clearing and settlement systems, and for regulatory policy in these areas. The framework for their co-operation is found in a Memorandum of Understanding, most recently revised in 2006. B. The Federal Reserve Took Extraordinary Actions to Save Institutions During the Global Financial Crisis, in Addition to Using Traditional Measures 1. The Fed Initially Used Traditional Policy Responses to the Crisis In general, the Fed took an extraordinarily interventionist approach to the global financial crisis. Initially, in September of 2007, the Fed responded to the subprime mortgage crisis by using its traditional tools to try to increase the supply of credit in the market. Specifically, the Fed lowered short-term interest rates dramatically, cutting the federal funds rate gradually until it reached a rate of between 0 and 0.25 percent. The Fed also used its open market operations (OMOs) to inject billions of dollars of liquidity into the banking system. OMOs are purchases and sales of financial instruments in the open market at the market rate. They are a central bank's principal tool for implementing monetary policy. In addition, in order to promote borrowing from the discount window, the Fed lowered the discount ratea rate that is higher than the federal funds rate. The discount window is a means of injecting liquidity that is different from the Feds open market operations. The discount window injects liquidity by lending to individual banks, allowing eligible banks to borrow short term (usually overnight) directly from the central bank. Thus, whereas OMOs target the system as a whole, discount-window lending provides support to particular banks that have a dire need for liquidity. 5

However, a major limitation of discount lending is that banks do not like to use it, as borrowing from the discount window may send a signal to the market that a bank has liquidity problems. Thus, at the onset of the global financial crisis, individual institutions that desperately needed funds were reluctant to borrow from the discount window because of the stigma associated with such borrowing. The Fed tried lowering the discount rate, permitted borrowing for a longer term, and even convinced some large banks to use the discount window to show others that it was okay, but nothing worked. The Feds use of the discount window as a traditional tool to inject liquidity proved to be insufficient, forcing the Fed to create new, unparalleled tools to deal with the crisis. 2. When Traditional Responses Were Insufficient, the Fed Created the Term Auction Facility To deal with the issues posed by the discount window, in December 2007 the Fed introduced a new method for providing liquidity: the Term Auction Facility (TAF). The TAF was a coordinated strategy among five central banks (United States, Canada, Britain, the European Union, and Switzerland) to provide struggling financial institutions with the liquidity that they needed. The goal of the TAF was to make funds available to a wider range of potential borrowers without the stigma associated with borrowing from the discount window. Thus, the Fed hoped that the TAF would act as a substitute for the discount window, providing financial institutions with much-needed liquidity in the midst of a freeze in interbank lending. Essentially, the TAF provides longer-term funding (twenty-eight to thirty-five days) on a collateralized basis, at interest rates and amounts set by auction. The discount window did not accept mortgage-backed instruments as collateral, but under the TAF, the institutions can bid with a wider range of securities as collateral, including mortgage-related instruments. In 6

a TAF auction, the bids begin at a rate above the federal funds rate, but well below the discount rate, thus providing institutions with at least the cover of a reason to borrow funds from the Fed through the TAF. Thus, no apparent stigma has been attached to borrowing from the TAF, and the response has been strong. Since December 2007, the TAF has held two auctions per month, and about sixty to seventy-five financial institutions have submitted bids at each. As of the end of 2008, the amount of funds provided by the bidding banks reached over $260 billion. 3. The Fed Created Additional Tools in Response to Failing Institutions In addition to the TAF, the crisis forced the Fed to take further unprecedented action, exemplified by its role in engineering the sale of Bear Stearns, one of the largest brokerage companies in the United States. After Bear Stearns encountered losses when two of its hedge funds collapsed in 2007, the Fed agreed to assist the company by providing it with credit. To do this, the Fed created the Primary Dealer Credit Facility (PDCF), providing Bear Stearns with credit on an overnight basis at terms equivalent to a discount window. However, when the Fed realized that this would not be enough, it entered into discussions with JP Morgan and assumed the risk of $29 billion in loss exposure in exchange for JP Morgans purchase of Bear Stearns. Although it could have done nothing, the Fed was not willing to allow Bear Stearns to collapse, as the resulting liquidation would have meant the dumping of billions of dollars in mortgage-backed securities into the market at a time when demand for such financial products was low. Further, given the investment banks extensive relationships with other banks, hedge funds, and other institutions, the Fed was worried that the failure of Bear Stearns would result in further failures.

In an attempt to ensure the survival of other investment banks, in March 2008 the Fed expanded the PDCFwhich it had used to help Bear Stearnsand also created the Term Securities Lending Facility (TSLF). Both lending tools accepted a wider range of collateral than the Fed had accepted prior to the subprime mortgage crisis. Specifically, the TSLF enabled broker dealers to borrow Treasury securities from the Fed in exchange for various other securities, including residential mortgage-backed securities, for up to one month. As noted above, the PDCF provided overnight loans to broker dealers at the discount rate and accepted an even wider range of securities as collateral than the TSLF. Notably, the PDCF constitutes the first time the Fed has ever lent directly to investment banks. However, although these unprecedented actions helped to provide much-needed liquidity to the markets, Bear Stearns would not be the only institution in need of rescue. In addition to the unprecedented bailout of Bear Stearns, the Fed also acted to support AIG, Fannie Mae, and Freddie Mac. In the case of AIG, the Fed initially loaned the insurance giant $85 billion in September of 2008, which gave it an 80 percent stake in the company. In regards to Freddie and Fannie, the Fed created a program to buy up their debt and mortgage-backed securities. Notably, however, the Fed refused to bail out Lehman Brothers, a decision many believed worsened the crisis. When it became apparent that the previously discussed Fed tools were not sufficient to stem the crisis, the Chairman of the Federal Reserve, Ben Bernanke, supported the administrations initial $700 billion bailout plan, which passed through Congress and was signed into law on October 3rd, 2008. The Emergency Economic Stabilization Act (EESA) gave the Fed increased power over short-term interest rates by allowing it to pay interest on reserves. The Fed used the authority granted to it under the EESA to create the Commercial

Paper Funding Facility (CPFF)a special purpose vehicle used to purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. A month later, in November 2008, the Fed announced the creation of the Term Asset-Backed Securities Loan Facility (TALF), which it would use to lend up to $200 billion to holders of certain securities backed by recently-originated consumer and small business loans. It was also through this facility that the Fed supported Fannie Mae and Freddie Mac, announcing that it would buy up to $500 billion in debt and mortgage-backed securities from the governmentsponsored enterprises. As noted, these actions by the Federal Reserve were unprecedented. In a speech on December 1, 2008, Chairman Bernanke said the tools the Fed created and used resulted in large increases in the amount of Federal Reserve credit extended to the banking system. By way of historical comparison, this policy response was exceptionally rapid and proactive. Many of these aggressive actions had not been seen since the Great Depression, and others were formulated to deal with the challenges accompanying the global financial crisis. 4. When Interest Rates Approached Zero, the Fed Introduced Quantitative Easing When interest rates approach zero, a central bank can no longer use the technique of lowering rates to stimulate the economy. Quantitative easing is a method whereby the central bank injects money into the economy by creating new money and then using it to purchase assets. The Fed announced its plan to use quantitative easing in March 2009, a few weeks after the Bank of England's successful introduction of the same strategy. The Fed chose to buy $1.2 trillion in government bonds and mortgage-related securities by printing new money in order to lower borrowing costs and thereby stimulate the economy. Though this strategy has advantages in that it encourages borrowing when lowering interest rates is

no longer an option, there are also risks involved. The Fed now holds huge amounts of assets, and if it cannot sell those assets as the economy recovers, the consequence could be massive inflation caused by the excess money circulating in the economy. C. The European Central Bank Used Traditional Policy Responses, Followed by a Delayed Decision to Purchase Bonds from Financial Institutions The European Central Bank (ECB) responded to the crisis quickly and aggressively. At the first sign of trouble in 2007, the ECB quickly injected 94.8 billion into the market to steady the Eurozone credit markets, and it did not charge a penalty rate for accessing these emergency funds. Like the Fed, from the beginning the ECB aggressively lowered its benchmark interest rate, and it has stood at 1.00 percent since May 2009, the rates lowest level ever. Also from the beginning, the ECB accepted a wide range of collateral, including mortgage-backed securities, when lending to struggling financial institutions. This contributed to the ECBs ability to address the crisis within its existing framework and thus, the ECB was not forced to create new tools for lending. However, in May 2009 the ECB announced that it would begin buying covered bonds from financial institutions, after an initial hesitance to use quantitative easing when the Fed and Bank of England did so in March. The purchases began in July 2009 and will total 60 billion in euro-denominated bonds rated AA or greater by at least one major rating agency. The ECB will purchase the bonds directly from institutions throughout the euro area in both the primary and secondary markets, and purchases should be completed by July 2010. D. The Bank of England Delayed Its Response to the Crisis, Then Introduced New Tools Generally, the Bank of England (BoE) took a non-interventionist, wait-and-see approach to the crisis, which was influenced by the division of responsibilities between the BoE, FSA, and HM Treasury. The BoEs response to the struggles of Northern Rock, the fifth-largest 10

mortgage lender in the United Kingdom, most convincingly evidences this characterization. Initially, when the company began to fail, the BoE was unwilling to accept its high-quality mortgages as collateral for emergency loans. In addition, in early September 2007 the BoE rejected a proposal from TSB (a major U.K. bank), which was willing to purchase Northern Rock in return for the BoEs guarantee of Northern Rocks deposits. The BoE stepped in only when Northern Rock was on the brink of collapse, eventually providing emergency funding to the company and guaranteeing $40 billion worth of liabilities. In addition to the BoEs delayed reaction to the failure of Northern Rock, the BoE initially left the bank rate unchanged and forced those accessing emergency funding to pay a penalty rate. The BoE also stigmatized borrowing from the discount window and only accepted restrictive high-quality collateral for loans. The BoE justified its conservative response by claiming that it intended to discourage excessive risk-taking and the repetition of a similar financial crisis in the future. As noted above, another reason for the BoE's waitand-see approach was that there was an initial lack of coordination between the FSA, the HM Treasury, and the BoEand the BoE cannot intervene on its own. However, as the global financial crisis ensued, the BoE was forced to act aggressively in unprecedented ways. For example, after its initial delay, the BoE broadened the range of accepted collateral in late 2007 and eliminated the penalty rate for emergency funds. In 2008, the BoE introduced the Special Liquidity Scheme (SLS), a program similar to the Feds TAF, to help inject liquidity and remedy the problems created by the stigma associated with borrowing from the discount window. Furthermore, the BoE's Monetary Policy Committee began aggressively cutting interest rates, and the rate is now at 0.5 percent, the lowest level in the BoEs three hundred-year history. On top of interest rate cuts, in February

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2009 the BoE set up a 50 billion asset-purchase program to buy assets including corporate bonds, commercial paper, and syndicated loans from eligible issuers. In March 2009, the BoE was the first of the three central banks discussed here to announce a quantitative easing strategy. The bond-purchasing program has expended 200 billion thus far, and faces the same problem as the U.S. Federal Reserve in that it must consider an exit strategy to avoid excessive inflation when the economy does recover. E. Though All Three Central Banks Acted Extraordinarily in the Crisis, the Level of Intervention Among Them Varied Throughout the crisis, all three central banks reacted in a similarly extraordinary fashion. For example, all three banks have collectively extended hundreds of billions of dollars in short-term loans to both commercial banks and investment banks. In addition, at one point in 2008, all three banks made a coordinated simultaneous reduction in interest rates. Although lowering interest rates is a traditional tool of central banks, the coordinated reduction was very significant. Central banks have also come together to promote new and innovative central bank tools to respond to the global financial crisis. For instance, the BoE and the ECB, among others, have coordinated with the Fed to create the TAF to provide long-term funding to banking institutions on an open-market basis. Similarly, the Fed has coordinated with the ECB and other central banks (not including the BoE) in a cross-currency swap facility in order to provide increased dollar availability in overseas lending. However, the broad similarities seemingly end there. Generally, the Fed and the ECB took a more interventionist approach to the global financial crisis than the BoE. From the first signs of the crisis, both the Fed and the ECB provided liquidity to the market, but the BoE delayed in providing assistance, due in part to its sharing of power with the FSA and

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HM Treasury. Moreover, the Fed was willing to provide assistance to Bear Stearns early on, while the BoE initially refused to help Northern Rock. Although the Fed and the ECB both played assertive roles in the early days of the crisis, the ECB was arguably even more interventionist than the Fed. The ECB acted even earlier than the Fed and accepted a wider range of collateral. This allowed the ECB to utilize its traditional lending tools to help struggling institutions, while the Fed was forced to create new lending facilities (i.e., TAF, TSLF, PDCF, etc.) in order to accept mortgage-backed securities as collateral for Fed loans. Some have speculated that the Feds actions were slightly delayed due to the Feds ongoing worries about inflation and its Congressional mandate to pursue maximum employment, stable prices, and moderate long-term interest rates. Facing a slowdown in productivity growth, a weak dollar, and increasing commodity prices, the Fed was reluctant to aggressively lower interest rateswhich could act to promote inflation and destabilize prices. Additionally, similar to the fears of the BoE, the Fed worried about moral hazard i.e., that stepping in to save financial firms that took excessive risks would only encourage them to take even bigger risks in the future. Finally, the Feds traditional policy (based on Alan Greenspans philosophy) of concentrating solely on controlling inflation and ignoring asset bubbles until they burst may have delayed its response. Since the Fed did not attempt to prevent the housing bubble from bursting, when it finally did act the Fed was initially unprepared to judge the severity of the shock and respond to it effectively. F. In the Future, Central Banks Need to Consider an Exit Strategy for Quantitative Easing, Rethink Structure and Philosophy, and Cooperate with Other Central Banks Generally, while the actions of all three central banks have prevented wider damage to the financial system, unprecedented and sometimes ad hoc changes to operational 13

frameworks were required (especially in the United States), suggesting that central banks were not well prepared for the extraordinary events that took place. In the midst of all of the uncertainty surrounding the global financial crisis, the central banks became lenders of last resorta role that some fear will lead financial institutions to accept unnecessary risks in the hopes that the central banks will bail them out if they happen to fail. Questions remain regarding how central banks should act as the recovery begins, as well as what they should do to try to prevent a similar crisis in the future. First, central banks must determine an exit strategy to avoid massive inflation as a consequence of quantitative easing when the global economy recovers. Second, it is possible that central banks, specifically the Federal Reserve, will consider substantive philosophical and structural changes to their operational frameworks. As noted above, former Fed Chairman Alan Greenspan abided by a philosophy of ignoring asset bubbles, as they are difficult to identify. Greenspan believed that the Fed should stick to worrying about inflation and the real economy, and if a bubble did burst, that the Feds role was to simply clean up afterward and limit the economic damage. Because the Fed followed this philosophy with regard to the housing bubble, it was unprepared for the aftermath of the burst. Will the Fed adopt a strategy of identifying and attempting to control asset bubbles? Only time will tell. In addition to analyzing the effectiveness of each central bank's tools and overall domestic monetary policy, many policymakers suggest that central banks should continue to reach out across borders to increase cooperation in order to more effectively address future cross-border crises. Central bankers seem to agreefinance ministers and central bankers from the Group of Twenty leading economies met in March 2009 and agreed to coordinated action in an effort to stabilize the global financial system.

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The global financial crisis will likely require central banks to evaluate their toolboxes and preventative and responsive philosophies in order to be more prepared should a similar global crisis ever happen again. Increased global coordination of central bank actions is sure to be a major aspect of reform. A global debate about the merits of increasing the regulatory powers of central banks has already begun and is likely to continue for years to come.

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